In addition to the rational economic theory that underlies any portfolio management strategy, it is also important to understand the psychological aspects of investing. While human beings have developed certain mental shortcuts to help us survive in our day to day lives, these same shortcuts often lead us to make poor decisions in situations characterized by complexity and uncertainty, such as investing. Recent research in the field of behavioral finance has uncovered several of these shortcuts that are hard-wired into our psychological nature:

Representativeness – The tendency to believe that what has happened in the recent past will continue to happen in the future. For example, the belief that stocks that are up since the beginning of the year will continue to go up and stocks that are down will continue to go down.

Herding – The tendency of people to do what others are doing, often despite evidence of danger. This bias can lead to asset price bubbles.

Activity Bias – The tendency to feel like we always need to be doing something, especially during highly emotional times. This often leads investors to trade too frequently.

Loss Aversion – The tendency for the feeling of pain from loss to be stronger than the feeling of pleasure from gain. This causes some investors to be far too conservative in their portfolio allocations or to exit the market after a period of decline.

Overconfidence – The tendency to place too much value on our own abilities. For example, many investors continue to attempt to beat the market despite overwhelming evidence that the odds are stacked heavily against them.

Unfortunately, these cognitive biases cannot be eliminated from our behavior – they are a part of the human psyche. However, being aware of these biases can help our rational mind to recognize when we are being influenced by them and allow us to make more informed decisions about our investments.

At Heritage, we have designed our investment process with an awareness of these cognitive biases. This helps us to more effectively guide our clients and ourselves through the ups and downs of the markets while minimizing the adverse impacts of the emotional and irrational aspects of investing.